The Canadian Securities Administrators (the joint body of Canada's provincial securities regulators) issued guidance on January 16th, 2020 that explains their thinking: the way that nearly all cryptocurrency exchanges operate around the world is in contravention of Canadian securities laws. The interpretation necessary to get there is inconsistent with other jurisdictions and poses risks to the Canadian digital economy outside of the cryptocurrency sphere.
This blog post explains what the latest guidance is, why industry players are concerned, and why it's problematic for the future. This is a very long blog post because of the complexity of this issue. Here's a brief table of contents:
1. What guidance was issued?
2. How does the CSA want cryptocurreny exchanges to operate? What do they consider to not be within the realm of securities laws?
3. What is the importance of "immediate delivery" in the CSA guidance?
4. What should cryptocurrency exchanges avoid doing, according to the CSA?
5. Why is this guidance surprising? How does it compare to other rule-making processes?
6. Why is the CSA doing this? How does this relate to "securities dealers"?
7. What do major companies think about the delivery issue? Specifically: Kraken, DV Chain, and Bitvo.
8. What is the danger of issuing guidance like this? Who else might be affected than the targets?
9. Is the CSA's position right, legally?
10. What have other lawyers said about this guidance? What will happen next?
11. What will the consequences of this guidance be?
What Guidance Was Issued?
CSA Staff Notice 21-327, "Guidance on the Application of Securities Legislation to Entities Facilitating the Trading of Crypto Assets", sets out the views of Canada's securities regulators with regard to how cryptocurrency exchanges delivery cryptocurrency to buyers. More specifically, the guidance explains the view that all cryptocurrency vendors/markets that don't deliver cryptocurrency "immediately" are likely dealing in securities, and are thus on the wrong side of the law. What's surprising about this guidance is that it goes beyond digital assets that are securities and instead is about platforms that involve buying or selling Bitcoin, Ether, and other cryptocurrencies that aren't generally regarded by practitioners or regulators as being securities (because they don't meet the various legal tests for what a security is). The CSA guidance focuses on the nature of how customers obtain the digital assets, and zooms in on the length of time between a buy order and the ultimate delivery of the cryptocurrency into an customer-controlled wallet:
"We generally will consider that there will be an obligation to immediately deliver if the contract or instrument creates an obligation on the Platform to immediately transfer ownership, possession and control to the Platform’s user and as a result there is delivery to the user (as described below)."
The guidance document should be read in its entirety, but one of the key passages that explains the above is:
"We generally will consider immediate delivery to have occurred if:
-the Platform immediately transfers ownership, possession and control of the crypto asset to the Platform’s user, and as a result the user is free to use, or otherwise deal with, the crypto asset without
A. further involvement with, or reliance on the Platform or its affiliates, and
B. the Platform or any affiliate retaining any security interest or any other legal right to the crypto asset; and
-following the immediate delivery of the crypto asset, the Platform’s user is not exposed to insolvency risk (credit risk), fraud risk, performance risk or proficiency risk on the part of the Platform.""
How Does The CSA Think Crypto Platforms Should Work?
The guidance document contains what the CSA considers to be an ideal example that would not be considered within the scope of securities legislation (at the bottom of page 3).
One of the requirements in the example nixes one of the most common models for selling cryptocurrency by requiring that "users send money to the Platform to purchase bitcoin at a given price". Most people don't send money to a platform to buy cryptocurrency at a given price, instead, they put in a market order (after transferring money to the platform because wire transfers can take days to receive) so that they can buy cryptocurrency at the market price, and not what the market price used to be (because markets are global and fluctuate quickly).
Another requirement in the ideal example is that the cryptocurrency has to be transferred to a user wallet, immediately, on a blockchain (not the private books of the company operating the service). According to this ideal example, that would rule out an exchange that allows users to buy and sell without having to transfer cryptocurrency in and out of a a wallet. Why is the transfer important to end users? At today's cryptocurrency network fees, a $0.10 or $1 transaction fee probably won't make this non-viable, but in the past fees have been upwards of $25 per transaction at peak times. There's value in allowing users to hold on a balance on an exchange, and in fact, a great many people prefer to leave cryptocurrency on exchanges rather than transfer it to wallets (and back) because of the complexity (actual or perceived) of using wallets. I think the complexity of wallets is overstated, but there's certainly many people who hold significant amounts of cryptocurrencies "on" exchanges, and they prefer to do this. Although many users aren't well-informed, there are many sophisticated individuals who choose to keep cryptocurrency on exchanges and don't want to have it "immediately delivered", and not for reasons that have anything to do with securities law.
It's not necessarily a problem for regulators to say that a business model is illegal or that the most common ways of doing business aren't acceptable, but if there are pro-customer reasons for why a model is being used, then that should be a reason to at least canvas the industry (and consumers) to see if maybe there's a way to gain the benefits of a more regulated system while minimizing the downsides of removing what customers like about the current model. Regulations have costs. These particular rules (technically, an interpretation that's not a rule) will have a heavy cost, as can be seen from the example the CSA gives of what they think is off-side.
What Should Cryptocurrency Exchanges Not Do According to the CSA?
The CSA has staked out a bold position on page 4 of the guidance. Their position is that "immediate delivery" is required of cryptocurrency platforms, and otherwise, the platform is (unlawfully) engaged in the business of trading securities:
"For example, if the terms and conditions of a contract or instrument transacted on a Platform only require the Platform to transfer crypto assets to the user-controlled wallet on request (with the transaction simply recorded on the books of the Platform to evidence the purchase and the user’s entitlement to receive the crypto asset on demand), the contract or instrument described above would be subject to securities legislation because:
-the contract or instrument does not create an obligation to make immediate delivery of the crypto assets to the user, and
-the typical commercial practice of the Platform is not to deliver, since users that do not make a request to transfer crypto assets do not receive full ownership, possession and control over the crypto assets that they transacted in."
After the above example, there's a note that the "immediate delivery" may really be more about "reliance and dependence of the user":
"In our view, a mere book entry does not constitute delivery, because of the ongoing reliance and dependence of the user on the Platform in order to eventually receive the crypto asset when requested."
Why Is This Guidance Surprising?
In 2015 the CSA's Derivatives Committee issued a consultation paper on Canada's derivatives rules:
"It is therefore important that rules developed for the Canadian market are aligned with international practice to ensure that Canadian market participants have access to the international market and are regulated in accordance with international principles to the extent appropriate. The Committee will continue to monitor and contribute to the development of international standards. In this context, it is hoped that this paper will generate commentary and debate that will assist the CSA in developing harmonized policies and rules that are appropriate for Canada."
When it comes to derivatives, and most other areas of regulation, the CSA (and its members) have carefully evaluated rules in other jurisdictions and there's a general sense that Canada's securities rules shouldn't be too far off other jurisdictions. But when it comes to "crypto assets", the CSA doesn't seem concerned with whether its new guidance is at odds with what's being done in Canada, elsewhere, or even whether it puts the existing companies out of business. The guidance that was released last week is a new direction for securities regulation, and the primary danger of this move is not whether it will affect the (small) Canadian cryptocurrency industry. The concern should be about regulatory overreach and where securities laws end.
Why don't securities laws encompass all economic activity in Canada? Because the economy would grind to a halt (and competition would be drastically reduced). The theory of our securities regulatory regime is that securities must be highly regulated to protect the public but that only a small percentage of economic activity ought to be considered as belonging within the regulated realm of securities laws. There are many reasons why securities rules are not a one-size-fits-all regime that can be applied to any type of business, and it's commonly considered to be one of the most restrictive and complex system of legal rules in Canada. There are limits to what securities laws cover. Does the new guidance go past the limits?
Why Is The CSA Doing This?
The CSA does not like that cryptocurrency activities haven't been carried out by securities dealers. This is evident from the context of this, which is within the wider consultation initiated jointly with IIROC (the organization that regulates securities dealers), and the first sentence of the guidance:
"[We] are issuing this notice to provide guidance on certain factors we consider to determine whether securities legislation applies to any entity that facilitates transactions relating to crypto assets, including buying and selling crypto assets (collectively, Platforms)."
Footnote #2 for the first sentence explains that when they use the term "Platform" it means: "Platforms may be "marketplaces" or dealers as defined in securities legislation." There's a bit of assuming the conclusion in this definition, but it certainly telegraphs what the CSA thinks, which is that companies that buy or sell cryptocurrency should be regulated securities market participants, or maybe even something more like a stock market (a "marketplace").
At the same time as the CSA appears to be of the view that securities dealers are the right people to undertake these activities, securities dealers have actually steered clear of cryptocurrency and generally have little interest in this novel but still relatively small industry. There's much more money to be made elsewhere, with far less complexity, risk, etc. There was nothing stopping them from getting involved before, but they didn't.
Will securities dealers now get involved in the market? Will existing companies need to change their business models? Will foreign cryptocurrency exchanges comply? The CSA guidance doesn't address these issues, but is clear that they would like this business to be carried on underneath the current regulatory system for securities market participants, rather than approaching this industry from an e-commerce perspective (or viewing it through another lens, there are many more to pick from than just securities such as the even more restrictive gambling regimes across Canada or through the Money Services Business lens).
What Do Crypto Industry Players Think About This?
The consultation that triggered this latest guidance began in the summer and received a number of responses from market players, some of which are relevant to this guidance. Below are some excerpts from the published comments of the players that relate to this guidance but note that the comments were submitted long before this guidance so they're not in response to this guidance but rather in response to the consultation that spawned the guidance.
Kraken is one of the largest cryptocurrency exchanges in North America. They do business in Canada, the US, and elsewhere. On page 2 of their comment there's an on-point submission:
"The assertion of jurisdiction over Exchanges is premised on the concept that even if a crypto currency is not itself a security, the contractual arrangement between an Exchange user (whom we refer to as a customer) and the Exchange operator may be deemed to be a security (or derivative). This premise implies that a customer’s interests or holdings on the Exchange are fundamentally different than the assets underlying the holdings, giving rise to risks that are separate and apart from those inherent to the asset itself. We respectfully disagree. This premise is faulty with respect to reputable Exchanges. As described below, most reputable exchanges operate as custodians or bailees. As such, the assets are legally owned by the customer and not the Exchange operator. This means, critically, that the customer’s interest is not derived from the underlying asset - it IS the underlying asset. The application of a securities law framework, accordingly, is both unnecessary and inappropriate to this structure."
DV Chain is a major player in the Canadian cryptocurrency space. In their comment they point to Ontario Securities Commission rule Rule 91-506 (unofficial consolidation) which specifically excludes derivatives that meet this definition:
"a contract or instrument for delivery of a commodity other than cash or currency that,
(i) is intended by the counterparties, at the time of execution of the transaction, to be settled by delivery of the commodity, and
(ii) does not allow for cash settlement in place of delivery except where all or part of the delivery is rendered impossible or commercially unreasonable by an intervening event or occurrence not reasonably within the control of the counterparties, their affiliates, or their agents;""
DV's comments explain how the defined scope of derivatives relates to other commodity products:
"In Canada, like in the US, if a commodity is not intended to be delivered, at the time of execution, it is deemed to be a derivative and therefore applicable securities legislation applies. It is clear, in both the spirit of the rule and accepted practice, that for a commodity that is intended to be delivered (such as gold, silver, platinum, palladium, diamonds, etc.), securities legislation would not apply, and the commodity would be treated as a spot commodity product. Therefore, a crypto asset that is intended to be delivered, would not be a derivative and should not be subject to securities legislation (i.e. treated no different than gold, silver, platinum, palladium, diamonds, etc.)."
Following their explanation of the derivatives rules in Canada, they provide an example of someone buying gold from an online platform in a way that hasn't to-date been considered a securities transaction:
"The meaning of “delivery” for crypto assets is an area which needs further explanation. This is best illustrated by comparing a crypto asset (like bitcoin) to a traditional commodity (like gold). If a client buys gold from an online platform, and that gold is:
• delivered (within a reasonable time frame) to a client approved vault;
• the client has first rights (and legal title) to the specific quantity of gold he/she just purchased
which is now being held in that vault;
• (and further evidence of legal title is demonstrated by segregation of the client’s gold from the
firm’s own assets and routine third-party audits of the vault to ensure physical existence of such gold),
then the gold has met the delivery requirement such that it is clearly a commodity and securities legislation does not apply."
Bitvo is a Canadian crypto exchange based out of Alberta. Bitvo's comment explains why cryptocurrency exchanges (everywhere) don't do immediate delivery to external wallets as the only, or even the default, choice, but they do always have a way of withdrawing if users would like to (and when they would like to):
"By requiring actual delivery of crypto assets on completion of each trade without the off-chain option, this would create logistical challenges, timing delays and increased costs as it relates to cryptocurrency-to-cryptocurrency trades as there may be discrepancies in timing of verification on the respective distributed ledger protocol underlying such transfer and the settlement of such transaction. ...
Many participants find the current process of handling and managing their own external wallet to be cumbersome or confusing and may take a less intensive approach to the security of their cryptocurrencies than the Platform would. Such participants appreciate a third party, such as the trusted Platform through which they acquired the cryptocurrency, taking care of that element of their cryptocurrency ownership. If a participant loses his or her private key to an external wallet, the cryptocurrencies may be lost forever. If such participant loses his or her password to the Platform, he or she would be able to recover the cryptocurrencies held on such Platform. Furthermore, by not settling every transaction on the applicable blockchain, the Platform and the participants are able to avoid mining verification costs and timing delays associated with the verification of such transactions on-chain. The transaction can occur in real-time and the participant can have the peace of mind that the trade occurred immediately exactly on the terms contemplated."
Coinsquare is one of Canada's largest cryptocurrency exchanges. Their comment explains why there are delays involved in delivery and how AML laws may even be the source of delays:
"There is no specific challenge associated with the transfer of crypto-assets from a Platform to a third-party wallet. However, “centralized” Platforms and OTC desks (albeit on a short term basis) must custody the crypto-assets or have an intermediary custody the crypto-assets to ensure each participant has sufficient funds to execute on a specific trade. Most, if not all Platforms have the ability to facilitate the actual delivery of crypto-assets to a participant’s wallet relatively quickly after a trade has been executed (however, note that crypto-assets may be temporarily withheld by a Platform in order to comply with anti-money laundering or Know Your Customer laws). The main benefit to participants of storing their crypto-assets on a Platform is that they do not have to manage their own wallet, which would require them to be responsible for storing their own private keys. We believe that the tendency for participants to keep assets on a Platform is rooted in convenience, particularly for frequent traders that are impacted by high confirmation times and mining/transaction fees associated with “on-chain” transactions and for participants who lack the technological savvy."
Note: Coinsquare's comment is from Coinsquare Capital Markets Ltd., which is (to my knowledge) not the legal entity that operates the Coinsquare exchange, but the Coinsquare logo appears at the top and this is the only comment submitted by any of the Coinsquare entities.
There's a wide diversity of views in the cryptocurrency industry. There are also many views from outside the industry that bear on the regulatory future of it and these views can be read in detail by browsing the 51 published comment letters here: https://www.osc.gov.on.ca/en/59631.htm.
What's Radical About This Guidance?
In the guidance, under the heading "When does securities legislation apply?" there's a key sentence:
"However, based on our analysis of how trading occurs on Platforms, we note that some Platforms are merely providing their users with a contractual right or claim to an underlying crypto asset, rather than immediately delivering the crypto asset to its users. In such cases, after considering all of the facts and circumstances, we have concluded that these Platforms are generally subject to securities legislation."
Many, many businesses in Canada do not "immediately" deliver what their customers have purchased. This guidance considers that it is the lack of immediate delivery which is the key characteristic that brings an otherwise non-securities transaction into the securities regime. Obviously the CSA chose the word "underlying asset" to bring this into the securities rubric, but what other kinds of businesses might be within the scope of securities laws if this guidance is more generally applied?
Online gold platforms operate like the CSA's example of what not to do. The gold platform example was explicitly raised in Kraken's submission to the CSA-IIROC consultation in May (quoted above) but isn't mentioned in the CSA's guidance.
All digital media stores (movies, TV shows, etc. ) sell by crediting the user with a license and then later allowing the person to download a copy of it. They could force immediate deliver of videos, but forcing users to accept a download at the time of purchase wouldn't always be the most convenient path and it's not how they operate because users wouldn't like it. Is the difference that there's additional IP involved (the video license)? Is it that the user can quickly but maybe not immediately get the video? Is it that there's no fluctuating market price? We don't know because the CSA guidance doesn't discuss any of this or what the impact of this line of thinking might be on other sectors.
If media is too different, what about video game currencies? For many years, video game companies have been selling in-game currencies that can be used to buy items (and there's secondary market trading). A good example of this is "shark cards" sold for Grand Theft Auto V, a game that has sold 110 million copies worldwide. Shark cards are sold to users and the delivery of in-game currency happens either immediately, or when the user enters the code to activate it. Is it problematic for companies to sell these types of virtual currency gift cards where the user receives a code that later leads to an in-game credit? Perhaps the key difference is that the code (which isn't the in-game money) is delivered immediately, whereas on most cryptocurrency platforms the cryptocurrency is only delivered after the user goes through a withdraw process.
It's common for digital goods, like tickets to shows, to be delivered long after the purchase date. It would be great if everyone could get their tickets immediately, but sometimes delays are necesssary for business reasons. One of the largest event ticket companies, TicketMaster, often has delays for resale or first-party tickets (and part of the explanation is anti-fraud). If these examples feel contrived, consider that the world is going digital. Digital items and digital assets aren't going away. So although today's examples might feel strained, it's hard to see where the line is drawn in the CSA's guidance, other than around cryptocurrency exchanges.
This is the kind of rule-making that may have a significant negative impact on the ability of Canada's technology companies to compete globally, or may cause them to simply not serve the domestic market and just pursue the markets of countries that haven't decided to expand the scope of securities laws (like the United States).
Securities laws have been expanding over time, to the point where one prominent US financial journalist wrote an article titled "Everything Everywhere is Securities Fraud". Is this the right area for Canadian securities law to expand into? Is it a good idea for the future economy?
Is The CSA's Position Supported By Law?
Does the CSA's guidance actually represent the state of Canadian law? That's an interesting question to ask about guidance issued by a securities regulatory organization, but there are reasons to think that the CSA has gone too far in their interpretation of the law.
OSC Commissioner Statement on Securities vs. Bitcoin Market
OSC Commissioner Lawrence Haber wrote in the matter of 3iQ Corp and the Bitcoin Fund (2019 ONSEC 37, paragraph 80):
"Although this doesn’t impact my conclusion about price manipulation and valuation, it is worth noting that bitcoin is a commodity, not an equity or other security. As such, the bitcoin market should be examined like other commodity markets and not held to the standards applicable to securities markets. The risk of market manipulation exists in all commodity markets. Many of Staff’s stated concerns could apply equally to other commodities, such as precious metals or foreign currencies. Staff did not persuade me that bitcoin is more susceptible to manipulation than other commodity products."
The above doesn't contradict the CSA guidance but it shows a tension that exists between regulating securities (as they're generally understood) and not regulating things that aren't securities. Not everything is a security. There are other regulatory regimes and it's important to not just apply the most burdensome, most restrictive rule system instinctively (and at the same time as other regulators are also staking out ground, such as the upcoming MSB change for virtual currency dealers in June).
Lack of Citations in Guidance
The CSA's guidance document cites only one law: the definition section of NI-14-101 that defines the term "securities legislation". That's not a lot of legal support for the CSA's viewpoint. Why doesn't the guidance explain the CSA's derivatives consultations? Why doesn't it explain the rules applied in other jurisdictions like the United States, the United Kingdom, etc.? Before issuing such significant guidance (which is read by a non-legal audience) I think it's incumbent upon the CSA and Canada's regulators to spell out their thinking and explain how this view fits into the wider debates about the margins of securities law. It's not enough to say that this is "guidance". This is an area of significant global uncertainty and legal development.
What Will Happen?
Two prominent lawyers from Osler (who were legal counsel for 3iQ in the case quoted above), Lori Stein and Evan Thomas, expect that the outcome of this guidance will be:
"We anticipate that given the size of the Canadian cryptoasset market and current market conditions for cryptoassets, some Platforms will question the feasibility of maintaining operations in the Canadian market and may choose to exclude Canadian customers, rather than face the cost and compliance burden of seeking registration as a securities dealer or exemptive relief from registration."
Another prominent Canadian law firm, McCarthy Tetrault, concludes their write-up about the guidance with:
"Though the notice acknowledges that it is possible to apply in the right circumstances for an exemption from securities or derivatives law and from the interpretive approach taken by the securities and derivatives regulators, the CSA makes it clear that they will pursue enforcement action or continue existing enforcement action against Platforms that do not comply with their interpretation of securities legislation."
How Will Exchanges React? What Could Happen?
Canada's cryptocurrency industry is resilient. But it's also quite small, and globally insignificant in cryptocurrency markets. When 95+% of the market is outside of our borders I don't think it's reasonable to expect global compliance with Canada's (unique?) view on how securities laws apply to cryptocurrency exchange. And if this puts Canadian businesses at a disadvantage, it's likely that foreign competitors will eventually put them out of business, and it will certainly hurt the export prospects of this nascent industry.
The Chair of the CSA (and President of the Quebec securities regulator, the AMF) claims that this guidance is to "... better support fintech businesses seeking to offer innovative products, services and applications in Canada". I doubt any of the businesses affected by this guidance consider it to be helping to support their businesss. Instead, they're much more likely to agree with Concern #3 from the Ontario Securities Commission's report on reducing reguatory burden (page 31):
"When rules are made, not enough attention is paid to how entities with different business models or of different sizes are impacted. The costs and benefits of proposed rules should be articulated more clearly. Rules, policies and guidance are sometimes drafted in a confusing or unclear manner. The OSC’s approach to regulation is often too prescriptive and the difference between rules and guidance may not always be clear."
Will Cryptocurrency Exchanges Campaign Against This View?
Unfortunately, Canada's cryptocurrency players are already operating in a challenging business environment and will be hard-pressed to come up with the necessary legal or lobbying resources to provide an alternative interpretation or an alternative regulatory proposal to address the dangers posed by the cryptocurrency exchange model (re: QuadrigaCX). I suspect the real pushback on the CSA's view will come when/if the regulators expand their sights from "crypto assets" to other commodities/digital goods/digital assets/etc.